Underwriting, in simple words, is a process in a financial world where a person or a firm will assess and take the financial risks in lieu of a certain premium or fee. The process is quite common where loan, insurance and trade of securities are involved.
During the Industrial Revolution era, many industries were cropping up, which required huge finances from lenders. In most cases, lenders would require someone willing to take the risk for the money in case the borrower is not able to pay the amount.
A borrower or lender would then appoint a person or a firm to evaluate the financial risk involved in the project. Based on the evaluation, the rate of interest was determined. The third-party in the transaction would write his/her name below the sum sanctioned for the borrower, and the person was eventually called underwriter.
The underwriter would take the project's risks and charge a premium on the total amount insured during underwriting.
The process is used even today, but the mechanism is different. In case of loans, borrowers take the services of underwriters to get fair rate of interest from the lender, which can be a bank, financial institutions, or a private lender. The lenders would get a kind of insurance for the money they are lending in case any defaults happen.
There are three major underwritings we encounter in the financial world more often. These include:
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Mortgages and other kinds of loans need to be evaluated on the basis of the borrowers’ financial position. The underwriting analyses include credit history, other running loans, income sources, and the collateral value that can be put on mortgage.
The underwriter in such cases will involve a human who can visit the location of mortgage and evaluate its market value. Further evaluation includes purpose of loan and details like income, savings, credit score and credit history and so on.
Based on the evaluation, the underwriter would assign the certain degree of risks and based on that rate of interest of the loan will be decided. If the rating is not satisfactory, loan sanctions can even be declined.
In the insurance sector, major risk involves too many people filing the claim together. The ongoing pandemic created one such situation where many people were admitted to hospitals simultaneously, leading to the majority of death occurring at the same time.
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Situations like pandemics increase the risk of the survival of the insurance sector as a whole. Under these underwriting services the underwriter tries to access the policy holder on the basis of its age, lifestyle, current health conditions, occupation, family medical conditions, hobbies, etc. All this evaluation helps in deciding whether insurance is to be granted or no and if yes then what’s the amount for the same.
Underwriting in securities is done usually during the launch of an Initial Public Offering (IPO). The company who is bringing an IPO would avail the services of an underwriter. In a case where the IPO is not fully subscribed, the underwriter would purchase the remaining shares which are not subscribed, after charging some premium.
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At a later stage, the underwriting firm would sell the shares in open market or to the institutional buyers. If the shares during IPO are fully subscribed, the underwriters will still charge a fee for taking the risk incorporated during IPO.
What are Capital Markets? Capital markets are the lifeline of an economy that facilitates funding for Government, corporations, and other institutions. Moreover, capital markets are funding infrastructure for the economy, therefore lifeline. Savings and investments are channelised to those in need of funding in capital markets. Investors and savers can include households and institutions, while capital seekers primarily include Governments, corporations, and institutions. Capital markets are the place where securities are exchanged between two parties. These securities incorporate equity, bonds, preferred shares, derivatives, commodities etc. Almost all financial instruments are traded in capital markets. Kalkine image Primary Market Vs Secondary Market Primary market is only concerned with the new issuance of securities. The moment security is exchanged between two parties after the initial issue, it happens in the secondary market. A company’s going public move is started through a primary market, where it directly sells securities to specific investors whereas once a company is public, it sells its securities (shares, bonds etc) to a large number of investors through the secondary market. Investment banks provide primary market services to capital seekers. A firm selling a bond goes to investment banks for underwriting, pricing, and listing of the security. Likewise, an initial public offering is also facilitated by investment banks for privately held enterprises looking for multiples. Market makers, brokers and dealers facilitate the secondary market for securities. Mostly these market participants are investment banks, but there are plenty of individual companies too providing secondary market services. Kalkine Image What are the types of capital markets? Stock market Also known as equity market, the stock market is the most popular capital market due to accessibility of investments. The liquidity levels in stock market are usually high, given the scale of market participants. Equity as an asset class has never faded for investors seeking capital appreciation. Stocks represent an ownership stake in the company, and stockholders have voting right on the decisions of the firm. A considerable portion of investors also includes households. Bond market Debt market provides large scale funding sources to an economy and is very crucial for economic development. Countries issue bonds in the debt market to fund their ambitions, while corporations and institutions have a similar intent. Bonds as an asset class is considered as safe because of regular interest payments on the principal amount as well as repayment of principal at the time of maturity. The risk of non-repayment of interest and principal is always present. Government bonds are considered as safest investments in the debt market, and yields on Government bonds depict the risk-free rate at a given point in time. Corporate debt is second to sovereign debt and is relatively riskier than the latter, therefore carries a higher interest rate. Commodity market Commodities are crucial for the global economy and have been factors of production in many industries. Unlike debt or equity, commodities have a movable presence and are traded extensively across global markets. As a resource, commodities have tangible demand and supply dynamic and are priced through these two market forces. While there are several types of publicly traded commodities, the popular ones include gold, silver, iron ore, coal, barley, grain, crude oil, platinum etc. Foreign exchange (FX) market The FX market is an essential part of capital markets, facilitating global trade and cross-currency flows across jurisdictions. Currencies and associated products are traded in the FX market. This market determines the exchange rate between the currencies of two countries. FX rate or exchange rate is evaluated based on the cross-comparison of various variables of two nations, including purchase power parity, the balance of payments, interest rates, inflation, GDP growth etc. Derivative market A derivative is a contract between two parties with an underlying asset, which would be exchanged on a specified future date at a pre-determined price. The value of a derivative contract changes consistently with the change in the value of the underlying asset. But the magnitude of change in the value of the derivative contract would be in multiples compared to change in the value of an underlying asset. The underlying asset to a derivative could be equity, bonds, commodity etc. Derivative also include structured products like total return swap, interest rate swap, swaptions, options, FX swaps etc. Private market A private market is a place where securities are exchanged privately between parties. Companies, before going public, trade in private markets. Private markets remain crucial for the development of new businesses and entrepreneurs. Businesses may experience significant capital activity in the private market. Private equity and venture capital are the prime examples of private market investors, seeking to invest in start-ups, ideas, and budding stories. Public market Public market is extremely transparent than the private market. In the public market, the investor base is large, and the information flow is extensive. All markets discussed above, except the private market, falls under the public market.
Lenders use qualifying ratios in the underwriting approval procedure for loans. Banks make use of qualifying ratios to identify whether the borrower is eligible for a mortgage or not.
The proceeds earned on the insurance policies the company offers to an insurer after excluding the expenses incurred and claims settled out. For instance, if a firm generates a revenue amounting to $60,000,000 from premiums and consumes $15,000,000 paying out claims, its underwriting income would be $45,000,000. Underwriting income level determines the exact measure of the efficacy of an insurer's underwriting actions.
What is an IPO? Initial Public Offering (IPO) is a process to raise money through a stake sale by existing shareholders by listing a company on a new stock exchange. It’s named IPO as it’s the first time a company is raising money through public forum though a particular stock exchange. The company, when private, usually depends on private funding from investors such as founders, friends, family, angel investors, and venture capitalists. Although private markets provide growth funding to budding companies, the ultimate exit of private investors is public markets. IPO is one of the funding sources of equity for a business. An Enterprise’s decision to go public is partly driven by the need for funding, and to attain a potential premium value to its assets, business model and future growth. Markets refer to this potential premium or discount as multiples because share prices of companies often trade in multiples of their underlying assets or profits. But many companies also trade below the perceived value of their assets and profit. A listing provides private investors with an exit route mostly at a premium, while founders also get paid if they sell a part of their stake. IPO funding is primarily used by the company to fund growth, repay debt, capital investment etc. IPO is a stock market launch of a company wherein shares are sold to retail investors as well as institutional investors. The process gives an opportunity to investors to assess and maybe take exposure in the potential growth of a business. Returns and risks come hand in hand, and it becomes imperative for investors to carefully evaluate the opportunity compared to the offering price of the securities. Not all IPOs end-up becoming a large-cap company, therefore it is essential to assess the associated risks. Please note: a company which is offering its shares to be public is not obliged to repay the capital invested by the public investors. What is the process of an IPO? Not every company is fortunate enough to sail through an IPO process. Going Public is a big step for a private company, which means that the company can now have access to a lot of money, giving it a better opportunity to grow and expand. Further, meeting disclosure criteria and share listing credibility can be used to negotiate for better terms in case of borrowed funds. And even after making into stock exchange bourse, there is no guarantee that the company will have a share price growth over the future. IPO process is complex and requires time, money, and substantial consulting. While investment bankers are inclined to take most of the companies’ public, it solely depends on the perception of public markets of the upcoming listing. Selecting an Investment bank: As step one, a company which wants its transformation to a public goes to investment bankers, for advice on the transaction and to provide underwriting services. Investment banks evaluate the prospects of a business and its past performance. They also look carefully at the business model, industry, and products of the company. An IPO prospectus includes a lot of information about the business that is mostly sufficient to evaluate an investment opportunity. Companies often select banks that have been engaged with the business in the past because these banks know in and out of the company. Other factors that impact the selection of a bank include the reputation of the bank, the ability to deliver quality research, and underwriting capability. Regulatory filings: Markets regulators regulate public markets across most of the jurisdictions. Since public markets come in the ambit of market regulators, IPOs are also monitored and evaluated by the regulators. This process also includes completing the underwriting agreement with the investment bank. Underwriter effectively acts as a broker between public market investors and the company. The investment bank or group of investment banks decide their underwriting capacity. In this stage, the company also provides necessary information and disclosure to the stock exchange and market regulator. It also registers the prospectus prepared by an investment bank. An IPO prospectus is an extensive document about the company’s business model, business fundamentals, management background, as well as legal information related to the IPO. Once the prospectus is registered, it is accessed by investors who are willing to invest in the upcoming IPO. Therefore, the prospectus of the company provides a base for investment decision-making of investors. Pricing of the IPO: After the necessary fillings and approvals, the investment banks that are handling the transaction undertake pricing of the company. The offer price of an IPO is based on valuation, market factors, and business performance. IPOs are priced in two ways. In a fixed price offer, the offer price of the shares is fixed by the investment bank based on the valuation; this process is usually applied when a small company is going public. In the book-building process, the investors submit their bids to the investment banks promoting the IPO transaction. This process is used for a large enterprise to obtain a maximum issue price for the stock based on the investors’ expectations. Once investment bankers receive bids, they evaluate the bids provided by investors and arrive at an issue price for the company’s share. Offer period: After the pricing of the IPO is completed, the offer period commences, which is given in the prospectus. During the offer period, the public market investors subscribe to the IPO of the company. This period usually decides whether the IPO is ready to hit the market or not. A company should achieve a minimum subscription to make debut in the markets. And the underwriting facility provided by investment banks seeks to ensure that minimum subscription is met. Allotment of shares: Once the offer period is closed, it is revealed whether the IPOs was oversubscribed or undersubscribed. If the issue is undersubscribed, the investors will receive the same number of shares subscribed by them. When shares are oversubscribed, the underwriters have the option to raise the price, offer additional securities or consider both. Advantages of IPO Primary objective is to raise money for a business. Whereas other benefits include: Facilitates completing acquisition deals, by helping in determining acquisition pricing and paying by issuing shares. Necessary transparency measures help in favourable terms of borrowing. Further funds can be raised through public, by going in for secondary offerings. Expands the company reach for money, its prestige, and improves its public image. Disadvantages IPO is a very expensive process and requires a lot of work. It not only needs expert services of investment bankers to be listed, but the cost of maintaining a public company is ongoing. The focus of the company management may change; a lot of effort goes under disclosing information. Original shareholders lose control of the company due to new shareholders obtaining voting rights. Sometimes practices inflating the share price of the company are used, which increases the risk and instability of the company.